Since mid-July, the stock market has undergone consolidation, accompanied by a minor 3 to 4 percent correction over the past one and a half months. This muted trend is expected to continue in the near term. The prevailing catalyst behind this declining trajectory is global rather than domestic. The biggest issue is the volatility in the currency market, led by a downgrade in the US credit rating and a slowing economy. Consequently, there has been an escalation in bond yields, casting a shadow on equity assets. The persistence of hawkish monetary policy coupled with elevated inflation, even when the economy decelerates, is significantly influencing market sentiment.
The secondary concern pertains to the downgrade in domestic Q1 earnings during the latter part of the report season. However, its significance is limited, as the aggregate Q1 performance remains robust. And corporate earnings are forecast to remain buoyant in Q2 due to a moderation in input costs and festival demand. Although the upswing in retail inflation observed in July has had a relatively minor impact on the stock market, it warrants careful observation due to its potential for upward movement. The possibility of heightened volatility looms if the inflationary pattern persists into August and September, driven by the dry season and El Nino effect.
To encapsulate, we presume the correction is short-term in nature, and the muted trend is expected to continue. India did better during this downturn due to a relatively restrained selling by Foreign Institutional Investors (FIIs). This outperformance is expected to continue in the long run owing to stronger domestic corporate earnings growth and lesser impact from the global economic slowdown.
Volatility in currency market
|US DOLLAR INDEX
|USD/INR SPOT RATE
|USD/EUR SPOT RATE
|USD/CNY SPOT RATE
|USD/JPY SPOT RATE
Source: Bloomberg, 17th August
Generally, when a nation experiences a downgrade in its credit rating, its national currency tends to depreciate. The US credit rating was lowered in July by Standard & Poor agency, but the value of the USD has been appreciating since. Paradoxically, this situation triggered swift downgrades in other currencies around the globe, resulting in high volatility in the world currency market.
This is because the downgrade of the US economy, the world’s strongest and biggest, has ignited fear in global financial markets. When such a dominant market experiences a setback, it inevitably reverberates across the rest of the world, leading to widespread repercussions. Anticipating a worldwide economic slowdown and sustained elevated interest rates, investors are turning cautious by directing funds towards safe havens like the USD. This will lead, especially for short- term investors (Hedge Funds), to reduce funds to equity assets. Notably, there has been a significant uptick in FII selling across countries like Taiwan, South Korea, Indonesia, and Thailand.
Increase in Bond Yield
The downgrade of the US economy is expected to increase the cost of bond paper; hence, market interest rates/bond yields are rising. The trend is to sell equity and buy bond. Interest yields have begun a gradual ascent both in the US and, to a minor extent, in India. This is also because of the continuation of high inflation, a slowing economy, and hawkish monetary policy.
High interest costs affect the financial performance of corporates. However, since the balance sheet position of India’s corporates is lean, a direct effect is not expected in the short to medium-term. However, effects will be high on heavy industries and debt-laden corporates, on a case-by-case basis.
Nevertheless, it will impact the pricing of the stock market, as Interest Yield and Equity Valuation have an opposite relationship. An increase in bond yield reduces stock valuation. The effects are expected to be more pronounced on the global valuation sphere rather than on India’s stock market, as India’s overall earnings growth is estimated to remain robust. The one year forward P/E valuation has reduced to below the long-term average at 18.3x (18.9x is the 5yr average).
Signs of high retail inflation to continue in the short-term
India witnessed a considerable rise in retail inflation to 7.44% in July, well surpassing the 6.4% consensus. This data markedly exceeds Q1’s (April to June) average of 4.6%. The market, however, remains relatively unperturbed by Q2’s robust price upswing, attributing it to be transient and expecting moderation in Q3.
Monthly inflation trend has already crossed the frontier
Source: CMIE, RBI
It could be premature to assume that inflation’s impact on the domestic market will be transitory. Because India is still under the risk of El Nino, if it really occurs, inflation will continue to be above the tolerance level of the RBI. The Indian Ocean Dipole, which was positive last month, has turned neutral. August’s rainfall is forecast to be the lowest since 1901. The level of heat is on the rise which will affect crop output in 2023.
In its August policy, the RBI revised its forecast upward and acknowledged the potential for additional upside risks. At present, the RBI foresees a reduction in inflation from 6.2% to 5.7% in Q3. The FY24 CPI forecast has been increased by only 30 basis points to 5.4%. However, the factual data for July and the climate conditions indicate a heightened risk beyond the RBI’s predictions, leading to an elongated withdrawal of the accommodative stance.
Further moderation in Valuation
In a general sense, high interest rates affect corporate earnings growth and valuation. However, the perspective is that India’s situation is poised for mitigation due to resilient domestic demand and the incremental influx of global orders fueled by China Plus One strategy. But invariably, high interest rate for a long time will have an impact on valuation. India’s one year forward P/E valuation has grounded during the year from 20x to 18.3x.
Investors are exercising caution as bond yields are making gains and emerging as a decent investment asset of high returns. The strategy involves divesting of equities and acquiring bonds. The US 10-year yield has increased to 4.3% from a low of 4.0% in the last month. Similarly, India’s 10-year yield has increased to 7.25% from 7.05%. However, the domestic market’s vulnerability is being restrained by low FII divestment in India compared to other emerging markets (EMs) and robust purchasing by Domestic Institutional Investors (DIIs) and retail participants.
Heightened divestment is notable in other EMs due to concerns related to deflation and the potential for default risk in China’s realty and finance sectors. Selling in US equities increased recently due to the downgrade of US mid-and small-sized banks. We can expect the selling from FIIs to continue in the short-term due to elevated global bond yields in developed countries, US devaluation (credit downgrade), and a slowdown in EMs, notably in China, potentially impacting EM’s performance. India is expected to decouple; however, the total return will be subdued and vulnerable to the degree of FII outflows in the short-term.
|Return based on local currency (%)
|MoM CHANGE (%)
|3MoM CHANGE (%)
|1 Yr. CHANGE (%)
|3 Yr. CHANGE (%)
|MSCI Asia Pacific
|MSCI Asia Ex Japan
|MSCI Emerging Market
Source: Bloomberg, Date: 18th August 2023